Investing in Energy: An Interview with James West

As we head into the last quarter of the year, James West questions how important macroeconomic trends are for individual investors. But he does believe stock catalysts in the energy space are easier to understand than precious metals market forces. In this interview with The Energy Report, West updates us on some possible top performers in the space and what they're doing right.

The Energy Report: James, with the U.S. election behind us, we are currently looking at a couple of looming and significant issues. One of these is QE3. You're not a fan of easing; tell me why.

James West: Quantitative easing is just the issuance of more money. Since the onset of the crisis, two episodes of stimulus/quantitative easing injected $2.3 trillion into the economy between 2008 and 2011. Real gross domestic product (GDP) numbers in that timeframe show GDP grew by roughly a net of $2.3 trillion, demonstrating that the "recovery" GDP growth rate of 1.2% was not in fact growth at all, but was merely the addition of 2.3 trillion newly fabricated dollars to the weak and stagnant GDP number. By distributing free money to the top layer of the financial food chain, Obama and Bernanke get healthy numbers. In other words, they are focused most intently on maintaining a delusion, and expend no effort on tackling the real problem, which is income and opportunity disparity.

TER: You have cited the practice of dividend recapitalization as a consequence of near-zero rates. You've written that it leads to a doubled rate of bankruptcies in companies undertaking that strategy. But shouldn't easing promote higher rates?

JW: Dividend recaps are the exclusive domain of private equity-owned corporations. The private equity owner causes the company to borrow so that the owners can be paid a dividend by the company. With such low interest rates, they can completely destroy the company over time, while paying themselves large dividends until the company goes bankrupt, and then they just walk away. They know that the United States can absolutely not withstand a rise in interest rates, or else it would have to declare bankruptcy as the cost of servicing debt would then rise to truly unsustainable levels. Super-low interest rates create the illusion of sustainable debt service levels to persist.

TER: Do you see this practice of dividend recap occurring in energy companies?

JW: Not necessarily. For private equity-owned energy companies, it's possible. But that would only happen if the earnings from energy sales were insufficient to provide income to the private equity owner. If the board of a public company tried that, they would be voted out, as the self-destructive nature of dividend recaps is obvious. The key requirement that makes a dividend recap possible is a strong balance sheet that throws enough cash flow to service a debt, which disqualifies 99% of the juniors. And again, it's not an option for a public company.

TER: Let me ask this counterintuitive question: Do you believe higher rates are important to the health of the economy?

JW: Interest rates are essentially the value of money. If you have interest rates at zero, and money is being created arbitrarily, then what does that tell you about the value of money? Zero interest rates mean banks don't make anything lending or investing money, so why should they? Meaningful and stable interest rates are absolutely characteristics of a robust and healthy economy. Zero interest rates are likely signals of impending economic collapse.

TER: The other major issue looming over the U.S. right now is a threatening fiscal cliff. What could be the upshot of this issue if it is not resolved between the president and Congress?

JW: There's all kinds of posturing by both sides to suggest there won't be a problem resolving the issue, and there won't be! It will likely go to the eleventh hour of course, as each side tries to exact concessions from the other, but at the end of the day, there's no choice. The bigger issue ahead of the fiscal cliff is the debt ceiling. Watch how quickly that gets raised. The U.S. can't afford another ratings downgrade.

TER: How do investors play your general economic theory? Back in the summer you told us you favored energy over gold. Is that still the case? Why?

JW: I don't think individual investors play economic theories so much. I don't think there are anywhere near the number of investors right now that there were in 2007. Yes, I favor the energy sector over the precious metals sector generally because it's easier to understand the market catalysts, which in energy are a little less controlled than in precious metals. The precious metals markets make no sense, unless you subscribe to the theory that the U.S. cannot permit higher gold prices, because a suppressed gold price is critical for maintaining the illusion that all is well in the United States Treasury and Federal Reserve.

The huge disparity in gas prices between east and west hemispheres is creating massive opportunity, and the rapid increase in North American shale-borne production is changing world energy dynamics by the day. In precious metals, you've got all the same fundamentals, but they're castrated by government-sponsored price suppression in futures markets.

TER: What about junior companies?

JW: Junior explorers are divided into two camps, as far as I'm concerned. Two years of severe underperformance have capped any possible upside in a lot of these older companies. They're practically pariahs, just waiting for the inevitable day when they run right out of money, and can't raise it at any price. There are many such "zombie" companies out there, but there will be a lot fewer this time next year.

Still viable are companies that match strong management with solid structures where the share price can still respond to success without battling through a wall of cheap paper from past financings. These are generally newer companies.

For specific ideas in junior explorers, my favorite companies now are Atico Mining Corp. (ATY:TSX.V), which we own in the fund. The Ganoza family is essentially recreating the winning recipe that they applied to Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE), though this time in Colombia. The company is acquiring a producing mine with plenty of exploration upside, and so you're buying into cash flow.

Mason Graphite (LLG:TSX.V) is a new graphite deal in which I own shares. I've been familiar with its graphite project for many years and I've spent time traipsing all over it. It's called Lac Guéret, and this was a hot graphite property in 2006, when it was owned by Quinto Mining, which was sold to Consolidated Thompson Iron Mines Ltd., which then was bought by Cliffs Natural Resources Inc. (CLF:NYSE). More importantly in the graphite game, however, is not so much grade and purity, both of which you need, but end users. Who are you going to sell it to? Graphite is not scarce. It's common. But CEO Benoit Gascon built the entire graphite sales channel at his former employer, Stratmin Graphite, from nothing to the point where it was bought by Imerys (NK:PA), one of the world's largest graphite vendors. In my mind, that is a critical differentiator that will make Mason Graphite one of, if not the graphite company of this cycle.

For lithium, I like Critical Elements Corp. (CRE:TSX.V), again not so much because it's the biggest lithium deposit, but because management is making all the right moves to put the deposit into production on a fast track. Ron MacDonald, the company's executive chairman, has a high profile within the alternative energy materials space, and serves several companies among whom synergies exist. Critical Elements is working to secure non-dilutive, commodity-based financing that could see it leapfrog ahead of other, more apparently advanced companies. Production I think will happen as soon as the company can find a buyer who wants to secure a supply of lithium, and will advance the funds to go to production on that basis. I know discussions are under way with a few groups, though nothing concrete has emerged yet.

TER: Do you have some other ideas you could share?

JW: I own the most shares in a stock I think is a billion-dollar company in the making. It's an OTC-traded company called Abakan Inc. (ABKI:OTCQB). It has now filed for a NASDAQ listing, and it has received investment from and is working with Petrobras, the world's fifth-largest petroleum producer, to supply Petrobras with a continuous supply of its nano-composite coatings for pipelines. Petrobras is producing highly corrosive oil from very deep fields, which creates stress for pipes gathering and transporting oil from offshore Brazil. Without Abakan's pipeline coating, much of the oil that Petrobras owns would be uneconomical to produce. And Petrobras is the tip of the iceberg for Abakan. Seventy percent of the world's remaining oil and gas supplies are "sour," meaning highly corrosive, and so that means demand for Abakan's MesoCoat pipelines should keep ramping up for decades to come. The company is looking at building plants in Indonesia, Bahrain, Brazil and Canada, besides its first plant, which comes onstream soon in Euclid, Ohio. The company recently won the Wall Street Journal's Technology Innovation Award in the manufacturing category.

TER: James, I'd like to get some updates on some of your picks from past interviews with us. To start, Aroway Energy Inc. (ARW:TSX.V; ARWJF:OTCQX) announced that it had acquired an additional 265 barrels per day (bbl/d) of immediate production. That's a runrate of about $1.3M per year just on this addition. The company has now increased production six fold this fiscal year. Shouldn't these additions be significant for a $27M cap company? When is this company going to get noticed?

JW: All the junior producers in the patch are in a state of suspension pending the outcome of Industry Canada's rulings on the two big mergers currently underway, yet not yet done deals. I'm referring to China National Offshore Oil Corp.'s (883:HKSE; CEO:NYSE) acquisition of Nexen Inc. (NXY:TSX; NXY:NYSE), and Petronas (PETRONAS) acquisition of Progress Energy (PGN:NYSE), which was initially turned down. This arbitrary move has put a big question mark over the valuations of the whole patch, from seniors to juniors, because the possibility of a buyout from a bigger company is one of the key price drivers in the sector. With the denial of the Petronas-Progress deal, global investors don't know who qualifies and who doesn't as far as purchasers go.

As that story starts to resolve itself, I think Aroway will start to see more of a lift in its share price. These days, if you don't produce 1,000 bbl/d, you're not even on the radar. So the company is technically already over that hurdle because it will exit 2012 with 1,200 bbl/d.

TER: EFLO Energy Inc. (EFLO:OTCQB) has recoverable access to 1.8–3.3 trillion cubic feet of natural gas. Gas may be cheap, but this stock is cheaper. Clearly the company suffers from being so small in market valuation where small-cap funds can't participate. But is it just a matter of time before the company is discovered by small hedge funds and investors? What catalyst can we anticipate?

JW: EFLO is owned by the Midas Letter Opportunity Fund, and has already been a double and then some for us. That's certainly one to watch, though it's early days for the company at this point. The big picture for EFLO is the development of pipeline capacity and a liquefied natural gas (LNG) plant on the west coast, which still has a lot of hurdles to clear. But it's going to happen. Canada needs the addition to the GDP. When the company starts drilling and bringing wells onstream, it will be able to move its gas to market—that's going to be the ongoing catalyzing event for the company's shares. That and getting a listing on a senior exchange, which I understand is in process.

TER: Prophecy Coal Corp. (PCY:TSX; PRPCF:OTCQX; 1P2:FSE) shares have had a rough time. It seems like the stock began to turn south when the company announced it was going into the power generation business in Mongolia. Did investors hate this deal because it took focus off of its core business?

JW: Not at all. It’s horrible share price performance is attributable exclusively, I would say, to the political situation in Mongolia, which is still uncertain, especially with the passage of the Strategic Entities Foreign Investment Law, passed in May 2012. This document has created more uncertainty than it has assuaged, and that's why Prophecy shareholders are suffering right now. Unofficially, there is basically a sense of optimism for the long term, and pessimism for the short term.

Just look at Oyu Tolgoi—no investment hesitation there on the part of Rio Tinto. Obviously, Prophecy Coal isn't Rio Tinto, and that's probably the main roadblock to reversing the share price performance. When it becomes apparent that Mongolia is not going to make a grab for the power plant, and clear investment and power offtake agreements are in place, the share price should start to appreciate. At this level, I think it's attractive.

TER: Recently the company announced a preliminary economic assessment on its Chandgana Tal coal mining licenses in central Mongolia, reporting 124 million metric tons of measured coal with a mine life of 30 years. How significant will this be?

JW: Well this was a big cloud put over the company by the Ontario Securities Commission, which has now been quite thoroughly addressed. In any other market, that should have been sufficient to attract buyers in the company's shares, but there just aren't a lot of those around right now, thanks to the overall weakness in mining companies for the last two years. Add to that a dose of political uncertainty, and you get the share price Prophecy has right now. But there's certainly no longer any question of there being sufficient coal to supply the power plant.

TER: James, thank you for your time today.

JW: My pleasure.

James West is publisher and editor of The Midas Letter, an independent capital markets entrepreneur and investor. He has spent more than 20 years working as a corporate finance advisor, corporate development officer, investor relations officer, and media relations and business development officer for companies involved in mining, oil and gas, alternative fuels, healthcare, Internet technology, transportation, manufacturing and housing construction.

By. The Energy Report

DISCLOSURE: 1) The following companies mentioned in the interview are sponsors of Streetwise Reports: Aroway Energy Inc., EFLO Energy Inc., Fortuna Silver Mines Inc. and Prophecy Coal Corp. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.2) James West: I personally and/or my family own shares of the following companies mentioned in this interview: Abakan Inc., Mason Graphite and Critical Elements Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.